By Andrés Velasco – Several central banks that began raising interests well before US and Euro-zone policymakers are still facing persistent inflation. But it was the right choice, because inflation was always likely to prove stubborn in today’s conditions, and waiting would have required even larger hikes later, with a heavier output cost.
LONDON – Brazil, Chile, Hungary, New Zealand, Norway, Peru, Poland, and South Korea: all raised interest rates early and high. But even after an average hike of six percentage points in the year to October, inflation is surging and growth is sagging. Have the countries in Hikelandia, as The Economist calls them, made a policy mistake?
Far from it. Moving before the US Federal Reserve and the Euro-zone was the right thing to do, precisely because inflation was likely to prove stubborn in today’s conditions. Waiting would have required even larger hikes later, with a heavier output cost.
The initial impetus for price increases came from collapsed supply chains and food scarcity caused by Russia’s invasion of Ukraine. It amounted to a cost-push shock to the world economy.
A second cost-push shock came from the strength of the almighty US dollar. All the countries in Hikelandia have floating exchange rates. As the dollar soared and their currencies sank, the domestic prices of imports rose, fueling inflation.
Every undergraduate economics student knows that containing inflation when costs are rising is tough, because firms will refrain from passing the higher costs on to consumers only if their sales are weak and prospects dim. This means that a given reduction in inflation will require higher interest rates, and hence weaker economic activity.
Alternatively, a given hike in rates will deliver less relief, and inflation will prove persistent.
It would have been nice if central banks in these countries could stop cost increases at the source. But, because they could not persuade China to relax its zero-COVID policy, or Russian President Vladimir Putin to stop raining missiles on Kyiv, or global financial markets to stop pumping up the dollar’s value, the blunt force of monetary policy was all that remained.
There was another reason why higher interest rates were inevitable. All the countries in Hikelandia rightly increased government expenditures in response to the pandemic. Cash transfers, furlough schemes, additional funding for doctors and hospitals, and support for small and medium-size enterprises – all of that was appropriate as the disease raged.
But pressing down on the budget accelerator is easier than hitting the brake. In several countries in Hikelandia, the fiscal boost lasted longer than it should have, making an offsetting monetary contraction inevitable. This was not ideal, but, again, central bankers had no alternative, given that they do not control fiscal policy.
In two countries, Peru and Chile, there was one aggravating circumstance: the foolishly shortsighted policy of allowing savers to withdraw funds from their private retirement accounts during the pandemic. Those savings were already insufficient to pay for decent retirement incomes; now, pensions will be lower still.
Both the Peruvian and the Chilean governments entered the crisis with small public debts, and they could have aided citizens without inducing them to dip into their retirement accounts. Moreover, the amounts withdrawn were so large that the increase in spending was bound to produce inflation. Chilean savers got their hands on US$ 40 billion, or more than 14% of GDP. Supermarket shelves emptied, and sales of imported cars and appliances skyrocketed, pushing the current-account deficit to nearly 9% of GDP. The central bank had no choice but to get tough.
But why did central bankers in Hikelandia move early, while the Fed and the European Central Bank fell behind the curve? Brazil was the first to tighten, in May 2021. Poland, New Zealand, and the others followed shortly thereafter. The Fed waited until March 2022, and the ECB until late July.
One possibility is that several of the countries in Hikelandia experienced high inflation recently, so voters and policymakers have a built-in aversion to price increases. That is probably true of Brazil and the other Latin American countries in Hikelandia, and perhaps also of the Eastern Europeans, but it is less plausible for New Zealand or Norway, where inflation has long been low.
Another possibility is that, with the exception of Brazil, most of these economies are small and quite open, and therefore imports account for a large share of domestic consumption. Add to that a sizeable stock of foreign-currency debt (which several of them have), and you have the components of what economists Guillermo Calvo and Carmen M. Reinhart once called fear of floating: a reluctance to tolerate depreciation causes policymakers to jack up interest rates at the first sign of currency weakness.
Turn these hypotheses around, and you have a plausible explanation of why the United States and the Euro zone delayed acting: both are large, not particularly open, and have not experienced high inflation recently. Policymakers seemed asleep at the wheel – until awakened by the loud noise of inflation spinning out of control.
True, core inflation has kept rising in much of Hikelandia, but it has not been all pain and no gain. In some countries, like South Korea, house-price infaltion has begun to cool, which often is a precursor of a slowdown in consumer price increases. In others, such as Brazil, inflation has come down sharply in the last two months.
The risk that inflation will remain stubborn has not vanished entirely. But there is also a risk that monetary policy will overshoot, with output dropping steeply, dragging inflation down with it.
One reason such a hard-landing scenario might materialize, emphasized by Maurice Obstfeld, a former chief economist at the International Monetary Fund, is that almost every central bank in the world is busy tightening, and, in doing so, they also help cool down other economies. If they fail to consider this spillover, says Obstfeld, they could trigger a “historic global slowdown.”
A narrow corridor between persistent inflation and a hard landing does exist. Having kept inflation expectations under control, Hikelandia could well steer its way down that path. Avoiding a slowdown is impossible; skirting a recession need not be. Early to hike, early to thrive? The central banks of Hikelandia hope so. May their hopes not be in vain.
(*) Andrés Velasco, a former presidential candidate and finance minister of Chile, is Dean of the School of Public Policy at the London School of Economics and Political Science. He is the author of numerous books and papers on international economics and development, and has served on the faculty at Harvard, Columbia, and New York Universities.